Factoring Exchange Rate Policy into your Investment Strategy: Risks Facing Andean Countries
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1 Factoring Exchange Rate Policy into your Investment Strategy: Risks Facing Andean Countries September 2011 Dr. Eliot Kalter President, E M Strategies Senior Fellow, The Fletcher School Ekalter@EMStrategies.com
2 Factoring Exchange Rate Policy into Your Investment Strategy: The Risks Facing Andean Countries Overview Capital Inflows Have Reached Pre Crisis Levels in Latin America Strong Capital Inflows, High Real Exchange Rates and Fast Credit Growth Surge in Capital Inflows Requires Difficult Policy Choices to Reduce Risks Exploring the Current Policy Mix to Curb Currency Appreciation: Where Are We Now? Should Investors Be Concerned about Wrong Policy Choices? The Bottom Line
3 EM Capital Inflows Have Reached Pre Crisis Levels EM capital inflows: an upward trend with periods of surges and sudden stops
4 EM Overall and Regional Capital Inflows Rapid recovery of net private capital inflows
5 EM Overall and Regional Capital Inflows A rapid recovery of capital inflows with levels approaching pre crisis levels in EM Asia and Latin America
6 Latam Country Experience with Capital Inflows Chile, Brazil, Colombia and Peru are all approaching pre crisis Inflows Gross Capital Inflows Gross Capital non FDI Inflows
7 EM Capital Inflows Continue in 2011 Advanced country sovereign debt problems and greater global risk aversion in 2011 have not stopped the rapid pace of EM capital inflows
8 Global External Imbalances Will Support Continued EM Capital Inflows Sizable global imbalances projected to continue in the medium term
9 Latin America: Strong Capital Inflows, High Real Exchange Rates and Fast Credit Growth We have seen that capital inflows are approaching pre crisis level in Brazil, Colombia, Peru and Chile At the same time we will see that: Real effective exchange rate is appreciated outside its 10 year range in Colombia and Brazil Real credit is growing rapidly in Brazil, Colombia and Peru and has reached its pre crisis levels in Brazil and Colombia This points to the need to better understand the required country policy response to maintain sustained economic growth
10 Latin America: Strong Capital Inflows, High Real Exchange Rates and Fast Credit Growth Capital Inflows in Brazil, Peru, Colombia and Chile are driving fast growth in credit to private sector and appreciation of real exchange rate
11 Latin America: Strong Capital Inflows and Fast Credit Growth Credit growth is above pre crisis levels in Brazil and Colombia
12 Surge in Capital Inflows Requires Difficult EM Policy Choices Exchange rate adjustment. Using the exchange rate as an automatic stabilizer may be the first policy option for countries with an undervalued exchange rate or when capital inflows are considered permanent Intervention. Economies may intervene to keep the exchange rate at the current level or to slow appreciation when countries need to increase their reserves or when capital inflows are temporary. However, sterilization of the liquidity injected by interventions can be expensive Monetary policy. Monetary easing can narrow the interest rate differential between foreign and domestic interest rates and, thereby, reduce the incentives for investors borrowing in low yielding currencies and investing in high yielding ones Fiscal policy. Fiscal tightening can support monetary policy by reducing the budget s financing needs and thus allowing for lower real interest rates Prudential regulation and supervision. Prudential ratios in the financial sector, such as liquidity ratios, which differentiate according to currencies, or reserve requirements that vary according to maturity can be used to influence capital inflows.
13 Surge in Capital Inflows Requires an Appropriate Policy Mix to Reduce Risks Some policy considerations The surge of capital inflows is likely to subside or even experience a sudden stop but Andean countries can expect strong secular capital inflows The permanent nature of strong capital inflows calls for these countries to partly absorb these inflows through an appreciation of the exchange rate However, especially for those countries with a significantly overvalued exchange rate, the brunt of the pressure on the exchange rate should be taken up by sterilized currency intervention (giving time for needed structural changes) This exchange rate policy should be combined with a mix of tighter fiscal policy and looser monetary policy to reduce incentives for capital inflows; extensive prudential regulations; liberalization of restrictions on capital outflows; and, if necessary, capital controls Once U.S. policy tightening begins, flows could slow abruptly. This is an additional reason for EM countries to ensure that their domestic policies are suitably countercyclical to enable a looser fiscal policy when needed
14 Exploring the Current Policy Mix: Where Are We Now? Brazil and Colombia have absorbed capital inflows through exchange rate adjustment
15 Exploring the Current Policy Mix: Where Are We Now? Deviations from equilibrium exchange rate estimated by Credit Suisse also indicate that Brazil and Colombia exchange rates are overvalued
16 Exploring the Current Policy Mix: Where Are We Now? Peru, and to a lesser extent Brazil, has also absorbed capital inflows through currency intervention
17 Exploring the Current Policy Mix: Where Are We Now? Colombia has been more aggressive than Brazil in using macro prudential tools
18 Exploring the Current Policy Mix: Where Are We Now? Brazil overheating exceeds that of most other principal emerging markets Peru appears close to overheating with output level above potential while its fiscal position is strong but is not being used as a policy tool to reduce pressures for capital inflows
19 Should Investors Be Concerned about Wrong Policy Choices? The IMF overheating indicators look at pressures on domestic demand and inflation and find Brazil over heating
20 Should Investors Be Concerned about Wrong Policy Choices? These indicators show: Brazil over heating without room to allow the exchange rate to absorb pressures from capital inflows Colombia has also lost room for additional exchange rate appreciation but is not over heating Peru and Chile are not seen as over heating and have more room for some additional appreciation of the exchange rate
21 The Bottom Line An Appropriate Policy Mix is Needed to Reduce Economic and Financial Risks To prevent economic over heating and asset bubbles, an appropriate policy mix is required that includes: Balancing exchange rate appreciation and intervention in combination with Tighter fiscal policy, looser monetary policy and prudential regulations to reduce incentives for capital surges and rapid credit expansion Liberalization of restrictions on capital outflows This appropriate policy mix will also help reduce risks in the face of a global economic slowdown or an eventual tightening of U.S. economic policies: Latin countries will eventually face another sudden stop of capital inflows The right policy mix now will allow EM countries to use countercyclical fiscal and monetary policy to offset external shocks
22 The Bottom Line The Andean countries are in a better position than Brazil to manage continued strong capital inflows and increasing private sector activity due to: Unlike Brazil, the Andean economies are not at the point of over heating Andean countries face a more manageable surge of capital inflows and growth of private credit There is somewhat more room for currency appreciation to absorb pressures In general, Andean countries are in a stronger fiscal position As a result, Andean countries are in a better position to gain from further capital inflows and implement counter cyclical policies in the face of any negative external shocks
23 The Bottom Line Within the Andean countries: Colombia Has surpassed prior peak levels of credit expansion but a still relatively moderate pace and does not have room for further currency appreciation but has actively used macro prudential measures and has room for additional currency intervention Peru Has rapid growth of credit to private sector though has not exceeded prior peak levels but relied on currency intervention and has room for currency appreciation it has a strong fiscal position but it is deteriorating Chile Is furthest away from over heating and has room for currency appreciation it also has a strong fiscal position which is improving in addition, Chile has greater flexibility for capital outflows than Colombia and Peru
24 Factoring Exchange Rate Policy into your Investment Strategy: Risks Facing Andean Countries September 2011 Dr. Eliot Kalter President, E M Strategies Senior Fellow, The Fletcher School Ekalter@EMStrategies.com
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